APPENDIX A
Economic Profit and the Key Value Driver Formula
In Chapter 2, we converted the growing cash flow perpetuity:
where
into the key value driver formula:
where
V = value of operations FCFt = 1 = free cash flow in year 1 g = growth in NOPLAT and free cash flow WACC = weighted average cost of capital
NOPLATt=1 = net operating profit less adjusted taxes in year 1 RONIC = return on new invested capital
The key value driver formula can be rearranged further into a formula based on economic profit. We do this to demonstrate that discounted cash flow is equivalent to the current book value of invested capital plus the present value of economic profit. A more general (and more technical) proof of their equivalence is provided in Appendix B. The economic-profit key value driver formula is necessary for estimating continuing value in economic-profit models.
By definition, invested capital times return on invested capital (ROIC) equals NOPLAT at time 1. Thus, we replace NOPLAT with invested capital times ROIC:
If we assume that the return on new invested capital (RONIC) equals the return on existing invested capital (ROIC), we can simplify the preceding equation by distributing ROIC ...
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